It Doesn’t Matter Much How Long It Takes for Prices to Return to Fair-Value Levels

Stocks are today priced at nearly two times their fair-value levels. Say that you acknowledge that it is likely that prices will return to fair-value levels in time. Does it matter how long it takes for this to happen?

Differences in return patterns matter. Those who are in retirement and who are regularly taking money out of stocks to cover living expenses should be hoping that prices remain high for as long as possible; that allows them to sell more shares at inflated prices, which of course is to their advantage. Conversely, those who are too young to have acquired anything more than very small portfolios should be hoping for prices to drop quickly; lower prices will permit them to acquire more stocks with their small regular payments and those stocks will be generating returns for them for many decades to come.

But does it really matter much in a general sense how long it takes for prices to return to fair-value levels?

Get The Full Seth Klarman Series in PDF

Get the entire 10-part series on Seth Klarman in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

I ask because I recall a conversation that I had with a Buy-and-Hold investor a number of years back. I was arguing that stocks were priced for a crash. He was not entirely dismissive of the argument; he agreed that valuations were very high in historical terms. But he had most of his money invested in stocks and thus had a hard time letting in the possibility that we were going to soon see a price drop of 50 percent or more. This was a horrifying thought to his mind. He argued that, while it was true that prices always return to fair-value levels, it did not have to happen by way of a stock crash; we might see prices remain stable for a number of years in which productivity gains not reflected in price gains ate up the overvaluation then reflected in the market price.

I found that argument entirely compelling in one respect and entirely unpersuasive in another. I agree completely that we cannot know in advance that fair-value levels will be restored by way of a price crash. It is certainly true that, if we saw no price gains for 10 years running, we would thereby wipe away the overvaluation without any price drop at all. Stock investors who saw no gains for 10 years would be missing out on gains of 65 percent of their portfolio values plus the compounding on those amounts if you compare their status with where they would have stood if stocks had earned their average long-term return of 6.5 percent real. That’s more than the one-time loss of 50 percent of portfolio value that it would take to bring prices to fair-value levels with a single crash event.

Price crashes are the most dramatic means by which prices return to fair-value levels but they are not the only means by which this goal can be achieved. But are they a better way of achieving the goal from the standpoint of an investor heavily invested in stocks? This I doubt.

Ten years without price increases for stocks is a horrible scenario for stock investors. There are calculators on the internet that permit people to estimate how long it will take for them to finance their retirements assuming different monthly contribution numbers and different return percentages. Think what a 10-year time-period with zero returns would do to the expectations of millions of investors who have been assuming that stocks will continue to pay out returns of something in the neighborhood of the 6.5 percent average long-term real return percentage. Those people would be experiencing a wipe-out! Without any word of a stock crash appearing in the newspapers!

Stock investing is a mind game. My internet friend thought of a stock crash as a catastrophic event. He was close to retirement. So I expect that he might have had a portfolio valued at something close to $1 million dollars. So the thought of a 50 percent crash was horrifying to him. The math is too easy. That’s a loss of $500,000. He couldn’t bear to even accept this as a possibility.

But he possessed a logical mind and so he couldn’t reject the claim that stock prices were likely to return to fair-value levels in not too long a time. He took comfort in the thought that we might get there through ten years of zero returns rather than through a 50 percent price drop all at one time. It’s a less dramatic way to lose money to be sure. But the financial loss resulting from 10 years without gains is worse.

I don’t think my internet friend was unusual. I suspect that, if research was done in which study participants were asked whether they preferred a 50 percent crash or 10 years without gains, most would choose 10 years without gains so long as they were not given time to do the math and thereby correct their psychological biases. If there is one thing that we humans don’t like, it is change and a 50 percent price drop is a big, negative, sudden change. Ten years without gains sounds far less menacing. If you don’t stop to think through what it means to go for 10 years without gains on your stock portfolio, it sounds like a neutral event.

It is anything but. Ten years without gains would be a national catastrophe. If all stock investors experienced 10 years without gains, we would all be behind in our retirement planning. We would all become afraid to spend. Which would cause many businesses to suffer setbacks and many employees to lose their jobs. A long stretch of time without gains would cause more emotional pain than a crash that quickly did the job of getting prices back where they needed to be and then let us put the bad stuff behind us.

The annualized real return for stocks from January 2000 through December 2016 was 2.27 percent. We are today living through a time-period much like the one that my Buy-and-Hold friend described as a possibility a good number of years back. Investors are not earning enough to finance their retirements. Most of us think of stocks as continuing to do well enough because the only price crash experienced in that time was largely reversed within a few months. But lasting gains have been modest for nearly 18 years now. We are hurting. Our economy is hurting. We don’t talk about it much because the hurt has been delivered in a non-dramatic, below-the-surface manner.